Futures contracts or futures are financial derivatives traded on an “exchange.” One example of an exchange is the Chicago Mercantile Exchange Inc. (CME) or CME Group (CMEG) which provides a marketplace where futures and options on futures are traded. The exchange establishes, for each market provided thereby, a specification that defines at least the products traded in that market, minimum quantities that must be traded, and minimum changes in price, which are often referred to as the tick size. The exchange operates as either an open outcry environment or an electronic trading platform. An open outcry environment is one in which traders exchange information by either shouting or the use of hand signals. An electronic trading platform involves software used to send an order to the exchange.
Traders access an electronic trading platform using trading software that displays at least a portion of the order book for a market. The order book contains previously received orders. In this way, incoming orders are matched with previously received orders. Through the trading software, a trader provides parameters for an order for the product traded in the market.
The term “futures” is used to designate all contracts covering the purchase and sale of financial instruments or physical commodities for future delivery on a commodity futures exchange. The financial instrument or physical commodity is referred to as the underlying asset or underlying instrument. A futures contract is a legally binding agreement to buy or sell an underlying asset at a specified price at a predetermined future time. The specified price is the futures price. The predetermined future time is the expiration date. Each futures contract is standardized in terms of underlying asset, quantity, and expiration date. An open interest holder of a futures contract that calls for physical delivery may be discouraged from using futures contracts because of volatility. An example of an open interest holder of futures contracts with aversion to volatility would be a hedge fund manager who is required to keep a specific position in a specific physical commodity or financial instrument. This type of open interest holder would prefer to completely hedge against price fluctuations in either direction.
Typically, this type of trader will maintain their market position from one contract period to the next by obtaining futures contracts with a more distant expiry as the futures contracts, which make up their current position, expire. This process is referred to as “rolling.” By rolling from one contract period to the next, the trader is able to maintain a constant position in the underlying commodity of the futures contract. Conventionally, futures contracts with expiries in the nearby delivery month are called the “front-month contract.” Futures contracts with expiries in the subsequent month or time period are called “deferred contracts.” For example, futures contracts that expire at the next available time period would be first-deferred contracts and futures contracts that expire two time periods in the future from the nearby delivery month would be second-deferred contracts, and so on.
Futures contracts that call for physical delivery are especially vulnerable to costs such as financing, insurance, storage, transportation, or others. Fluctuations in these costs can dramatically impact the cost of delivery and can cause the price of futures contracts to vary dramatically. This volatility gives rise to costs to open interest holders who intend to roll their market position to the next contract time period just prior to the expiration of the front-month contract. These costs discourage open interest holders, who wish to maintain their current position, from continuing to use futures contracts that call for physical delivery.
Four strategies are available to open interest holders who wish to maintain their current positions in futures contracts that call for physical delivery. First, open interest holders may attempt to roll their current positions prior to the commencement of traditional roll periods. The roll period is the time period when the market for the first-deferred contract begins to develop. One example of the first strategy may be seen in Treasury futures.
FIGS. 1 and 2 illustrate historical data for the roll period for exemplary Treasury futures. The roll period is shown in the graphs where the percentage of open interest in the deferred month contract increases dramatically. The roll period may be defined as the time period from the time that open interest in the second expiry passes through the 10% and 90% thresholds. However, it should be noted that the 10% and 90% thresholds are exemplary and only one possible illustration of the roll period. For the 2-Year U.S. Treasury Note futures contract, as shown in FIG. 1, the last trading day occurs on the last business day of the contract month and the first delivery date occurs 19-23 business days before the last trading day, as shown by box 10 in FIG. 1. Accordingly, the roll period occurs during an 11 to 13 day window that straddles the first delivery day of the expiring contract, as shown by box 20 in FIG. 1.
For the 10-Year U.S. Treasury Note futures contract, as shown in FIG. 2, the last trading day occurs on the seventh business day before the last business day of the contract month. The first delivery date occurs 12 to 16 days before the last trading day, as shown by box 30 in FIG. 2. Accordingly, the roll period occurs during an 11 to 13 day window that straddles the first delivery day of the expiring contract, as shown by box 40 in FIG. 2.
Open interest holders may attempt to roll prior to the commencement of the roll period to avoid adverse price movements in the futures calendar spread. For example, the holder of a March contract (front-month contract) could attempt to roll his position into a June contract (first-deferred contract) before the roll period begins. However, this strategy is significantly limited by the availability of a party who is willing to sell June contracts before the roll period. Trading in the second expiry is generally modest at best. Normally, open interest holders who attempt this strategy find market liquidity insufficient to roll from the current front-month contract into the first-deferred contract prior to the established roll periods.
A second strategy, available to open interest holders who wish to maintain their current positions in futures contracts that call for physical delivery, would be to attempt to roll their current positions from the front-month contract into the second-deferred contract thereby skipping or bypassing the first-deferred contract altogether. Normally, open interest holders who attempt this strategy find market liquidity insufficient to roll from the current front-month contract into the second-deferred contract prior to or during established roll periods. Rolls into the second-deferred contract may be very difficult or impossible to execute because very little futures activity occurs in the second-deferred contract during the traditional roll periods from the front-month contract to the first-deferred contract.
A third strategy, available to open interest holders who wish to maintain their current positions in futures contracts that call for physical delivery, would be to close out their positions in the front-month contract prior to the last trading day and then to re-establish their positions in the first-deferred or second-deferred contracts later in the hope that overall market conditions that cause volatility will have subsided. Open interest holders who attempt this strategy are significantly exposed to market risks because they have closed out their positions completely for a short period of time.
A fourth strategy, available to open interest holders who wish to maintain their current positions in futures contracts that call for physical delivery, would be to simply exit the futures market and move their business to the over-the-counter (OTC) market. Moving to the OTC market is not attractive because of the high administrative costs, limited market access, poor market transparency, and counter-party risk exposure of transacting in the OTC market.
It would be desirable to facilitate open interest holders who wish to maintain their current positions in futures contracts that call for physical delivery.